Cyprus turmoil leaves rating agencies eyeing downgrades

LONDON, March 20 (Reuters) - Rating agencies may give euro zone authorities an extra headache as Cyprus's up-in-air bailout plans leave them eyeing downgrades of the island and its banks and wondering whether it hurts the rest of Europe's lenders.

Efforts to rescue Cyprus were thrown into disarray on Tuesday after its lawmakers rejected the conditions for a 10 billion euro European Union bailout after baulking at plans to seize individuals' savings via a levy on bank deposits.

It has left the island's leaders scrambling to avoid a meltdown of its finances and oversized banking system. Credit rating firms, whose assessments can be a major influence on access to funding for countries and banks, are watching the situation closely.

Fitch Ratings said the situation remained too fluid for it to make a decision on Cyprus's sovereign rating but warned that if a levy on savings went through it would be judged to be a "restricted" default by Cypriot banks.

Although it would not necessarily be automatic, debt issued by those banks could face the same fate.

Senior bank debt ratings "have also been placed on Negative Watch to reflect the heightened risk of some form of negative rating action or default because of the crisis," Fitch said in a statement on Wednesday.

Bank bonds, like sovereign debt, can be exchanged for ultra-cheap funding at the European Central Bank. The money has kept the euro zone's troubled lenders afloat during the bloc's debt crisis but assets in default cannot be used.

For Cyprus's teetering banks, that could prove fatal.

It is also likely to mean Mario Draghi and his colleagues would again have to bend the ECB's rules and allow Cyprus's tiny national central bank to provide them with so-called "emergency liquidity assistance" to have any chance of survival.

The ECB has said it stands ready to provide support but only within its "existing rules".

Standard & Poor's refused to comment on Cyprus's situation but Moody's said it too would class a deposit grab as a default by the banks. It also warned that it could be damaging for the rest of Europe, as it would erode confidence in the EU's system of insuring deposits up to 100,000 euros.

"The losses are credit negative not only for Cypriot bank creditors, but also for other European bank creditors since this is a significant step toward limiting or removing systemic support for bank creditors," the firm's top sovereign risk and chief credit officers said in a note.

Depositors have long been assumed to come first in the queue for repayment if a bank runs into trouble.

MIXED SIGNALS

At Caa3, Moody's has the lowest sovereign rating for Cyprus of the three major firms.

It warned the bailout could have a negative impact on that rating if it sparks a new slump in the economy. But at the same time, it could benefit it by reducing the overall burden on the island.

The determination to avoid another Greece-style default could also help rebuild confidence in the wider euro zone.

"By removing the risk of a sovereign restructuring for now, the agreement reduces contagion risk for sovereign credit markets and supports our base-case assumption that policymakers in the euro area will act to preserve the monetary union in its current form," its note added.

DBRS, one of four rating firms whose assessments are used when the ECB decides whether to accept a bond as collateral, does not rate Cyprus but its head sovereign analyst, Fergus McCormick, said the bailout plans raised euro zone-wide issues.

"The questions being asked are if depositors are taxed in Cyprus, could they be taxed in other countries? And: if junior bank bondholders are being asked to participate, will senior bank bondholders be asked at some point in the future?"